Wall Street Watch: EMS investors have reason for concern

As we enter first-quarter earnings season, investor sentiment has weakened since better-than-expected results were reported for the December quarter. While concerns over the Iraq war may be a contributing factor, we believe signs of weaker demand started to emerge much earlier. For example, January printed-circuit-board shipments and orders fell 25% and 14% sequentially, respectively. In February, PCB orders fell another 3% sequentially, and March doesn't appear to be much better, based on conversations we had at the IPC's Annual Presidents' meeting.

We believe the decline in PCB orders helps explain the recent downward trend in sales expectations. Currently, we are forecasting a 13% to 15% sequential decline in first-quarter core EMS sales, excluding OEM asset divestitures, down from a 10% to 12% decline estimated after fourth-quarter results were available. However, consensus sales expectations for a group of nearly 50 technology hardware OEMs representing $545 billion in market capitalization reflect an 11% sales decline, double the 5% decrease originally forecast. Interestingly, even an 11% sequential decline is less than the 13% average decline realized over the prior three years. Could this imply further disappointment when results are reported?

With the economic recovery stalling, investors would benefit from further understanding the difference in underlying business models. While nearly all

EMS stocks are highly volatile, the virtual model offers greater financial stability of the two primary underlying business models. In addition to providing core design, material procurement, assembly, test, and logistics services, vertical EMS providers fabricate some major components in-house. During the tech boom, the public vertical EMS providers, like Flextronics, Sanmina-SCI, and Solectron, spent billions of dollars on acquisitions to grow these supplementary businesses, while virtual EMS providers like Benchmark, Celestica, Jabil Circuit, Manufacturers' Services, and Plexus focused on growing their core EMS services.

Over the past few years, the differences in these two models have become clearer. For example, virtual EMS providers, which represented less than 30% of 2002 sales, generated nearly 85% of the $1.9 billion in free cash flow over the past four years; made 3.1% margins on earnings before interest and taxes in 2002 vs. 0.6% for vertical EMS providers; recorded restructuring and goodwill charges totaling $1.6 billion vs. $10 billion for their vertical counterparts; and generated a median return on invested capital of nearly 8% vs. 1% for vertical EMS providers.

In essence, virtual EMS providers tend to be less capital intensive and generate more sustainable margins and less volatile ROICs by focusing intently on a few core capabilities. During periods of uncertainty, these characteristics warrant attention--even vs. many large, technology hardware OEMs, which are often trading at significantly higher earnings multiples, despite greater technological risk, weaker balance sheets, and poorer 2003 earnings estimates.

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This information is intended to provide a recap of previous information or opinions with respect to the referenced industry but is not intended and should not be construed as an analysis that provides information reasonably sufficient upon which to base an investment decision. Readers of this market commentary should consult research notes and reports on the subject companies and discuss the information contained therein with their financial consultant prior to making any investment decision regarding the subject company.

The author is employed by RBC Dain Rauscher Inc., a securities broker-dealer with principal offices located in Minnesota, U.S.A. The author of this report has received (or will receive) compensation based in part upon the investment banking revenues of RBC Capital Markets (including RBC Dain Rauscher, RBC Dominion Securities Inc., and RBC Dominion Securities Corp. or their affiliates). RBC Dain Rauscher Inc. makes a market in the securities of Celestica Inc., Flextronics International Ltd., Plexus Corp., and Sanmina-SCI Corp. and may act as principal with regard to sales or purchases of this security. A member company of RBC Capital Markets or one of its affiliates managed or co-managed a public offering of securities for Sanmina-SCI Corp. in the past 12 months. The securities of Celestica Inc. discussed in this report are subordinate voting shares.